Option traders who wrestled iron condors and other types of non-directional, income-producing combination trades during April and May have been glad to see the rally take a breather. For those who don't trade non-directional, income-producing trades, strong trends require income traders to gather all the tools in their adjustment-and-hedging strategy toolboxes and go to work. The action since June has produced a welcome respite.

However, the consolidation prompts other questions. Are the markets topping or just pausing while recent gains are consolidated? I might prefer non-directional options strategies these days, but I haven't abandoned my technical-analysis roots. Those roots prompt me now to study volume patterns for clues. Too often, volume considerations are left out or misunderstood when traders look for clues to next market direction.

My first suggestion would be to start with on-balance volume (OBV), an indicator that I would have discussed in this article, except that Leigh Stevens wrote an excellent Trader's Corner article on the topic on June 4. I consider the indicator an important one and Leigh an authority we're lucky to have on the site. Perhaps some new to the site aren't aware of Leigh's background, but he's the author of Essential Technical Analysis: Tools and Techniques to Spot Market Trends. A former Vice President of Equity Sales and Trading Division at Cantor Fitzgerald and past contributor to CNBC.com, Leigh's experience certainly urges us to pay attention to anything he writes. I believe, as does Leigh, that OBV can be an important technical analysis tool in any market participant's toolbox.

Why is volume so important that Leigh would write about it and now I am about to cover a different slant on volume? In a Trader's Corner article titled "Collinearity," I pointed out that volume serves as an independent indicator when making any market decision. Volume is not directly correlated with price. An up move can be produced on high, average or low volume. Ditto with a down move. A doji, a candle produced when prices close at or near the opening level, can be accompanied by lackluster volume, average volume, or explosive volume. Each combination of price action--the result--and volume--the effort extended to reach the result--means something different. While other indicators are derived from price action, we need an independent variable to help us decide whether volume patterns corroborate or contradict price patterns.

Annotated 10-Minute Chart of the SPY, June 5, 2009:

Leigh's article included a chart that noted the "volume 'climax'" in March as markets hit their March lows. Tom Williams, author of Master the Markets, would also urge us to study such volume patterns, buying or selling climaxes, when looking for market turns. As Williams often explains, explosive volume means that institutions are involved. We retail traders can't produce that volume on our own, trading among ourselves. But what are the institutions doing? That's what Williams wants us to consider, both when institutions are clearly involved, as evidenced by the explosive volume, or when they're not, as evidenced by lackluster volume.

Because our primary question now is whether markets are just pausing or are topping on at least a short-term basis, I thought it might be a good idea to review some of the points Williams makes about topping markets. His comments are sometimes contrary to the commonly accepted lore. Williams, his bio says, "spent 12 years . . . working with an off-the-floor professional trading syndicate," and his view of the markets is through the eyeglasses of a syndicate or institutional trader. He looks at volume patterns to decide what the institutional traders are doing, and he warns traders of the tricks that syndicate or institutional traders can use to manipulate markets. Having been behind the scenes, he's not as shy as I would be about using words such as "manipulate," "trap," and "trick" when discussing the actions of the institutional traders. I don't tend to call anyone names and most former professional traders I know would dispute Williams' characterizations. However, his warnings of institutional actions should perhaps be heeded, since he worked behind the scenes.

Whether we agree with Williams' characterizations of the actions of institutional or syndicate traders, we'd all agree with his assertion that retail traders want to trade on the same side as those traders, not against them. Williams' views can be startling and somewhat contrary to what we've usually been taught, as evidenced by the SPY's 10-minute chart. Those views are also elegant and logical when the thinking behind them is understood.

Williams explains the situation depicted in the SPY's chart in a section titled "How to Tell if a Market is Weak or Strong" (28). He sets up a scenario in which markets have been rising, but market makers and other professional traders have actually begun switching sides and now have large sell orders. They're selling into the gap higher, and their selling "will tend to keep the spread of the day [my note: in the SPY example, substitute "10-minute candle" for "day"] narrow, by limiting the upper end of the price spread." Gaps up on weakness tend to occur early in the morning, he warns, and the gap is likely a gap into a new recent high.

Gaps on strength can occur in the morning, too, as institutional traders take steps to ensure that nervous longs don't abandon their positions after a period of consolidation. We likely saw some of that action in early May. These trades will be accompanied by strong volume that drives prices higher in a broad range. There's no selling that keeps the spread of the day low.

However, strong volume is as different from explosive volume as it is from lackluster volume. Williams counsels that explosive volume on an up bar, particularly if the bar for that period closes well off its high, often indicates distribution, not strength. Here's how Williams puts it when discussing the case of an up bar with a narrow spread, accompanied by greatly increased volume: "professional traders have started to transfer stock to eager uninformed (or misinformed!) buyers" (33).

If volume always indicates the presence or absence of institutional traders, as Williams caution, their presence or absence, coupled with the spread of the day's candle or bar, reveals their secret intentions. If they're buying, they're certainly going to be able to absorb the supply that retail traders might be unloading, and so prices will continue to go higher. If they're dumping stock, though, even if they're begin careful to maintain prices as much as possible, we retail traders won't be able to absorb all they're dumping and prices may pull back from their highs by the close of the period, as they did on that SPY chart.

Sometimes other signs of weakness may be found when institutional traders appear to be absent from the markets and volume sinks to lackluster levels. Their absence on rallies is suspect, too, with their absence indicated by small-spread, low-volume candles that move mostly sideways, creating a rounding-over top that Williams calls the "characteristic mushroom shape" (31).

That's some background, although I'm sure I've likely done Williams' some injustices when summing up his theories so succinctly. How does that apply to what we're seeing on the charts? When I look at the DIA or SPY's monthly chart, I don't see a mushroom or gradually rounding-over shape. Neither do I see a narrow-spread up bar accompanied by explosive volume, although we can't yet exclude the possibility that such a candle will be produced in June. Unfortunately, I don't see any of the signs that would give us a definitive "Aha! It's topping!" signal.

Unfortunately, neither do I see definitive "Aha! It's advancing on strength!" signs on monthly charts, the charts I'm studying for the best long-term view. It's possible I see something else that at least alerts me to pay attention. Williams puts all this talk of volume confirmation into perspective in a section on "Effort versus Results," with that phrase forming the gist of his theories. "Effort to go up," he writes, "is usually seen as a wide spread up-bar, closing on the highs, with increased volume" (39). Later, he adds, "If the market is not supported by professional activity, it will not go very far."

Our markets have arguably already gone "very far." However, have they, when see on a monthly chart? And what does that monthly chart say about professional or institutional involvement? How are the monthly bars or candles acting? Are they closing at their highs on strong volume, indicating that institutions are involved and they're buying? I'm afraid that confirmation we'd all like to see isn't there on the monthly charts.

Annotated Monthly Chart of the DIA, as of 6/18/2009:

I've used the DIA here, but I could have chosen the SPY, IWM, or QQQQ's. Each allows an examination of volume patterns, which pure index charts don't, and each chart displays the same features.

I don't fancy myself an expert on Williams' theories, but I do find them helpful. What they tell me now is not a proof of an imminent rollover but instead constitutes, in my opinion, signs of weakness or lack of institutional support as part of the rally's background. Such signs don't always result in a rollover and especially don't result in an immediate one. Institutions can be wrong, and we've all heard the recent speculation on fund managers that "didn't get in" and were waiting anxiously for a chance to do so.

For example, as early as last October, the huge volume and big bounces off the lows on monthly charts began predicting that some accumulation had begun, but it was a painful passage of many months into March before a temporary bottom was found. I don't know whether institutions were wrong, buying too early, or were willing to endure the pain as they started buying ahead of the actual bottom, as they sometimes do. Since they have to accumulate or distribute in size, they sometimes do so by moving early, accumulating while prices are still on the way down or distributing while prices are still on the way up.

What I do know is that I don't see the institutional support I'd like to see in this rally. The decreasing volume and small upper candles each month has contributed to my unease.

Williams counsels that once we see weakness in the background, we should be alert to several signs. Those include the narrow-spread up-bar that pushes "into new ground" on high volume, the type of bar discussed earlier in the article. Another sign might be what Williams terms an "up-thrust," a "wide spread up . . . to then close on the low" (78). He says that up-thrusts sometimes occur after weakness has already appeared in the background, when a period of selling has occurred. The up-thrust follows. He suggests that it can be seen in either high or low volume. High volume, coupled with the result, shows that supply overcame the demand. Low volume shows that there just was no demand.

Williams further suggests that market makers "are quite capable of generating an up-thrust, which is a moneymaking maneuver." It's not hard to do, he says, once that weakness and then bout of selling are in the background. A bit of good news might allow market makers to mark up prices quickly, trapping shorts and the bulls who want to catch that runaway rally train. Prices are then supported for a while but then sink back by the end of the day or the period of the candle.

A buying climax can be another sign that markets are topping, with this climax occurring at market tops. We'll have to see what this monthly candle produces. So far, I see signs that make me wary, including the current shape of June's monthly candle, but that's it. Just because I don't yet see definitive signs that do anything other than make me wary doesn't mean Williams' theories don't have value. I rarely engage in directional option trades on equities these days, but if I do, it's often been on a signal that Williams' work taught me to recognize.

If you're interested in reading Williams' book, an Internet search will probably turn up a free download. They're offered free from time to time. I can't guarantee how reliable those downloads are (virus free, etc.) as I paid a tidy sum for my copy purchased through more regular channels, just before those downloads began appearing. Production values aren't great in the copy I purchased, so I don't think you'd lose anything in the downloaded versus purchased copy.

Linda Piazza